The yields on Italian bonds soared through the crucial 7pc level effectively shutting out Europe's third biggest economy from capital market funding.

Rome was left floundering as its sacrifice of Prime Minister Silvio Berlusconi failed to reassure markets and created even greater confusion.

Analysts warned that Italy was now a "lost cause" and "staring bankruptcy in the eye" - while Europe lacks the mechanism or firepower to support it.

Fear ripped through the sovereign bond market taking Spanish, French and Belgium borrowing costs to the highest levels for almost twenty years.

Last night there were reports that Germany and France had started preparing for the imminent break-up of the eurozone. Senior Brussels officials told reporters that plans were being drawn up for a "smaller eurozone" consisting of "fewer members" who would push forward towards economic and fiscal union. The officials insisted this was not about a "two-speed" Europe that has been discussed in recent days but a radical re-drawing of the entire euro project.

Separately members of Angela Merkel's Christian Democratic Union Party have reportedly called for processes to be introduced to allow countries to quit the eurozone, according to Germany's Handelsblatt.

In Greece, George Papandreou, the son and grandson of prime ministers, finally announced his resignation - but failed to confirm his successor. The expected appointment of Lucas Papademos was apparently toropedoed by Evangelos Venizelos, the ambitious finance minister. Frantic talks with the president and different factions continued into the night with an announcement promised for this morning. European authorities have said Greece will not receive its vital €8bn tranche of aid until Athens has agreed on new leadership and the government has committed to economic reforms.

The chaos in Europe rattled stockmarkets around the world. The Stoxx Europe 600 closed down 1.7pc, Germany's DAX and France's CAC dropped 2.2pc each and Spain's Ibex 35 fell 2.1pc. In London the FTSE100 dropped 1.9pc. In America the Dow Jones fell more than 3.3pc in late trading.

Herman Van Rompuy, the president of the European Council, insisted that Brussels was in control. "We are resolutely determined to guarantee the financial stability of the eurozone, the stability of the eurozone is also vital for the world economy," he said.

Italy faces a big test today with a €5bn auction of sovereign debt which officials insisted would go ahead as planned.

Rome was convinced that markets would be reassured by the resignation of Mr Berlusconi, the cause of a political deadlock that has in turn blocked the passage of economic reforms. The dogged prime minister confirmed he would step down - but not until the Stability Act was passed.

The uncertainty led LCH Clearnet to raise its deposit charges on 10 year Italian bonds from 6.65pc to 11.65pc. The move doubled the costs for Italian banks that were buying government debt. The banks started dumping Italian 10-year bonds which triggered the soaring yields. Although the European Central Bank moved swiftly to pull yields down by buying large amounts of Italian bonds, by the end of the day 10-year yields were still at 7.25pc.

Barclays published a note saying Italy was "mathematically beyond the point of no return". Once yields were above 7pc, Greece lasted 13 days before requesting a bail-out; Ireland lasted 15 days; Portugal held out for 49 days.

Fears of contagion pushed Spanish yields up to 5.8pc. French borrowing costs rose 1.46 percentage points above German bonds - the widest spread for 19 years. Just six month ago, Italy's spread over German bunds was 1.2pc.

Economists urged Germany and France to unleash the power of the European Central Bank by allowing it to become a lender of last resort. Others said even this would be too late. Alberto Gallo of RBS said: "The situation has deteriorated so dramatically...I do not think the ECB on its own could bring back the market to the point before Italy succumbed to contagion."